High-protein diet unhealthy for Sysco

JeffMiddleswart

Sysco
SYY, +0.61%
may have been the perfect growth stock for much of the past two decades. By delivering products to the fast-growing restaurant and food-service industries, and by regularly acquiring smaller competitors, the company produced enough EPS growth to turn even the head of a tech stock junky.

SYY benefited from the great American restaurant and waistline expansion. It faced no technology obsolescence, no Amazons
AMZN, -0.11%
no Apples
AAPL, +2.02%
and no leaking oil rigs. No wonder the company is a Dividend Aristocrat and favorite of many dividend lovers.

But now Sysco looks more like another big company with limited growth prospects. The company generates $39 billion in revenues while it spends about $100 million annually on acquisitions. That means buying regional distributors no longer moves the needle for SYY. As a result, the company is more at the mercy of large, macro trends than ever before.

And for a while at least, the trends look like this: Higher food costs, higher fuel costs and a weak customer base. In our view, this spells margin pressure as SYY's inability to pass on costs crimps the bottom line.

Let's start with beef. Scarce water, sparse grass and rising feed costs led ranchers to cut their herds sharply last summer. SYY benefitted from the lower beef prices as inventories surged. Now, with herds the smallest since the 1950s, cattle prices are soaring, up 10% per hundredweight in March year-over-year. Exports markets are also strong, further pressuring beef supply.

Chickens are a similar story as high feed costs hit chicken producers too. So after ramping up production in 2010-2011, chicken producers rushed to cut the size of their flocks last summer. As a result, frozen chicken inventories surged to multi-year highs, but by year-end, those inventories were at multi-year lows. No surprise then that whole chicken breast prices are 23% higher YTD. And like the cattlemen, chicken producers are exporting more, with Pilgrim's Pride's exports up 40% last year.

The problem for SYY is that protein (beef, poultry, dairy and seafood) represents 44% of sales, and SYY needs to pass on those costs to its customers to maintain margins. But most of its customers are restaurants. In fact, they account for 62% of sales. Generally, restaurants can't pass on double-digit cost increases to their budget-conscious customers. If they do, they well see far fewer of them. Given the high fixed-cost nature of restaurants, they'll fight to avoid that scenario.

Diners also trade down to avoid price hikes. If a beef meal jumps 25% in price from $16 to $20, they trade down to chicken even if chicken rises from $8 to $12 a 50% increase. Now, both the restaurant and SYY make less revenue than before even with some food inflation. That unwinds fixed-cost leverage, too.

Yet it's critical that SYY pass on these higher costs because every 0.1% drop in gross margin costs SYY 4.3 cents in EPS. SYY's margins are already under pressure from rising food costs generally. And this is before the protein cost inflation hits. In fact, protein was a margin benefit the last three quarters.

2Q12

1Q12

4Q11

3Q11

2Q11

1Q11

4Q10

Gross Margin

18.0%

18.4%

18.6%

18.6%

18.8%

18.8%

19.2%

Food Inflation

6.3%

7.3%

5.9%

5.1%

4.5%

3.3%

2.2%

If SYY can't pass on most of its higher costs, can't it just cut expenses?

It already has. Since the recession, employees are down from 50,900 to 46,000. The number of trucks is down to 8,700 from 9,300. Routes have been reworked for efficiency. SYY's trucks are getting older, and capex is on the rise again. Depreciation should eventually move higher as well.

Of course, there is something worse than failing to fully pass on higher food costs. That is passing on no food costs at all. Some of SYY's contracts are fixed-price in nature. For example, those with schools and hospitals. These are negotiated annually, not when farmers find themselves short of cattle.

Higher fuel prices aren't helping SYY either. The company does implement fuel surcharges, but not for all of its customers. But the real problem for SYY is that high gas prices could crimp diners' pocketbooks, making it even tougher for the SYY to recoup its higher food costs from restaurants.

Admittedly, SYY is the dominant player in this space, and its dividend is not in jeopardy. But given that protein costs are moving from a tailwind to a headwind, EPS estimates certainly are.

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